This Is What It Looks Like When 'No Brainer' Trades Go Spectacularly Wrong

With Islamic State militants gaining ground in Iraq, Russia going
head-to-head with the West over an uprising in Ukraine and chaos
in Libya earlier this year it looked inevitable that numerous key
oil producers were set for a squeeze. This presented one clear
and compelling conclusion — oil prices were set to rise.

And so the money flowed — and flowed — into the trade. In fact,
bets by traders in the oil market that prices would rise reached
their highest level in over a decade:

Traders have flooded out their positions with "liquidation in net
speculative length ... such that Brent is outright short with WTI
net spec positions far off their highs," according to a note from
Goldman Sachs.

The reason for the collapse? Almost every story traders were
telling themselves about why oil prices just had to rise turned
out to be wrong.

The Libya Story

Libyan rebel fighters with
the Tripoli Revolutionary Brigade after a live firing exercise
during a graduation event near Nalut in western Libya on Aug. 6,
2011.Bob
Strong/Reuters

Crude oil supply disruptions in Libya became a big problem again
in 2013 with the US Energy Information Administration reporting
that "from the end of July to the end of August, crude oil
supply outages in Libya more than doubled" as the country fell
back into civil war. This helped push prices higher and increase
concerns about the prospect for further supply disruption.

Following protests in Kiev that saw the Ukrainian president flee
the country and his government collapse, a secession movement in
eastern Ukraine has been battling the Ukrainian government. These
rebels have the political support of Russia, and many believe
Moscow has also been supplying them with on-the-ground support
including military hardware and personnel.

In response, the US and the European
Union have imposed sanctions on Russia targeting the
country's banks, oil, and gas industries and imposing travel bans
on numerous Russian citizens. Again, it seemed clear that Russia
would either impose limits on oil exports itself as a tit-for-tat
measure or would struggle to maintain the same level of trade
with the West while the crisis continued.

Output of oil and gas condensate in the world's largest producer
rose 0.9 percent to 10.61 million barrels per day (bpd) last
month [in September] from August, a touch under the post-Soviet
record-high of 10.63 million bpd reached in December, Energy
Ministry data showed.

The Iraq Story

Islamic State militants
operating across the porous border between Syria and Iraq have
seized control of large swathes of land in Iraq.

The group's early success
against Iraqi government forces caused many to worry that the
country's oil producing infrastructure could ultimately be taken
or damaged if fighting continued.

However, Iraq was also able to
shrug off international fears, adding 134,500 barrels a
day to take its total production to 3.164 million
barrels a day in September. Output rebounded because of higher exports
from the south of the country and increased output from fields in
Kurdistan,
according to Reuters.

Small wonder then that traders
are panicking. Once again we have seen the difficulty markets
face when trying to price in geopolitical risk.

This also works both ways —
widespread overconfidence about price increases can quickly
become overconfidence in the likelihood of further price
decreases. As Goldman said in its note:

If the market does go much lower, we could see the mirror
image of what occurred in the 2000s in that lower deferred
prices kill off supply growth and stimulate demand.